Updated: Dec 29, 2021
It was the 1920s when electricity was becoming mainstream in America, and the economy was booming post World War 1. The world had witnessed the emergence of a new section of society called the middle class, which was growing rapidly in number post WWI. Migration from rural areas to urban areas shot up. More and more factories were coming up, and of course, Wall street was roaring. The 1920s is often called the “Roaring twenties”. Building on post-WWI optimism the wall street soared to new highs, with General Motors leading the rally. And yes, when everything seems alright it is time to be cautious. A few years down the lane in 1927 the federal reserve lowered the interest rate from 4% TO 3.5%. This was the start of the bubble. So, when interest rates go lower, more people and businesses borrow money, and with more money in their hands, they buy more goods and services. So, when people started to spend more, other people who were providing services and goods to them earned more due to high demand. The money being spent would now be the earnings of another person, and as the person earns more and more selling goods, he becomes eligible for loans by banks, so he borrows money, and again spends it, here another seller earns money. Now the second seller earns more and more and becomes eligible for loans by banks, and he borrows too. This is a chain reaction where everyone in the system borrows, and there is a huge influx of capital to the economy. This chain reaction makes the economy boom, as there is more spending, and more spending means more selling, more selling means more production, more production means more employment, and more employment means more people qualify for loans, and more loans mean more spending, and all through it again. Therefore, the entire economy starts to boom. In 1927, when the federal reserve lowered interest rates from 4% to 3.5% more people started borrowing to invest in the stock market (trading on margins was now easier). This made the already high stocks go even higher, which again encouraged more people to borrow and do the same (profiting off the surge). This made the Dow Jones Industrial Average go from near 150 to 380s within 3 years. But at the same time, the Margin debt to buy those stocks tripled in three years. Stocks were trading at near 30 PE ratios. Similar to 2008 and now. Right now, the S&P 500 PE stands at 29.27 as of Nov 1, 2021. High returns in the stock market invited new uninformed investors to the market, similar to the scenario today. Wall street invented new financial instruments to borrow more money to make even higher returns, like call loans and investment trusts. They operated outside the regulated banking system and were known as the “Shadow Banking system”. As the market went up more speculators were betting in favor of the Bull run, and on the other hand, lenders were making a good amount of money through interest on loans. It looked like the market would go up forever. In 1928, the fed realized how bad the situation of speculative debts was and decided to increase the interest rate from 3.5% to 5%. As interest rates were increased, borrowing reduced and the influx of cash into the market seemingly stopped, and the high valuations couldn’t stay afloat with less cash in the system. By March 1929, the fed started holding secret meetings every day but didn’t tell what the agendas of the meetings were. This raised speculation and sparked rumors that the fed was going to crack down on borrowing for stock investments. In August 1929, the fed again raised the interest rates from 5% to 6%. Just as how lowering the interest rates, increases cash flow and helps the economy boom, increasing interest rates does the opposite. Since there was less influx of money into the stock market, prices didn’t go up for some time, so people became nervous and withdrew their positions from the stock market which made the market fall a bit. As I had explained earlier that reducing interest rates, increased the income of people who provided goods and services, increasing interest rates had the opposite effect. Since people had less money to spend, people on the selling side earned less, and this was a chain reaction, so the average earnings started to drop. And with earnings dropping, the economy was in trouble. The Chain reaction goes on and on, and one final day in October 1929 the bubble pops and the market crashes, and the economy plunges. For nearly a week the market went on achieving lower lows. Now the economy was in real trouble, 1930-32 was the period of economic depression. And since the market went down and people lost money, the banks got into a tough spot because most of their lending was down the drain. Now banks had less cash to give to legit businesses, and this was another chain reaction. When businesses couldn’t get enough loans/ capital they got into a tough spot, expansion of business was impossible, and since businesses didn’t have enough capital, they started firing people, which led to an unprecedented rise in unemployment. This also happened in 2008, leading to many jobs being lost. When people knew that the banks were in trouble and were being squeezed, people rushed to banks to withdraw their deposits, and since banks only keep a portion of their deposits with them and lend out the rest, banks collapsed too overwhelmed by the huge number of withdrawers. And on December 11, 1931, the biggest bank in the US collapsed. This continued the vicious cycle that started from increasing the interest rates. And with banks closing, even good businesses couldn’t borrow money, so they had to fire more and more people in order to survive, people were left jobless and homeless. It took nearly 8 years for things to cool down, and in 1939 World War 2 started. In 1932 the banking act was passed giving the federal reserve the right to print money. This is called “Quantitative easing”.
Coming to 2008, when the market crashed, the fed brought down the interest rates to near zero percent to stimulate the economy. As I had explained earlier lowering interest rates, creates a virtuous cycle and would bring more money into the system, more money means more spending and more spending means more earnings to sellers. This was done to stimulate the economy and not to create another bubble like in the 1920s. This was meant as an energy drink to the economy. But this energy drink was given for the next 6 years. No president wanted to repeal that and increase interest rates. Low-interest rates meant higher economic recovery/growth rate, and this meant more employment, and more economic growth translated to votes, so if any president chose to increase the interest rates, it would be political suicide, as that would put a full stop to the never-ending amazing economic recovery and growth. Therefore, the stock prices rose and the housing market boomed. As a result, we have witnessed the biggest rise in the housing market and the stock market which lasted for 131 months, just like the 1920s and the 2008 scenario.
In 2016, trump swears in as the new president and has the fed slowly raise interest rates, but in 2020 the pandemic hits, and the economy is again under pressure, so they had to lower interest rates again. And the fed started printing more money which they call “Quantitative Easing”. In fact, according to a report dating back to Feb, 40% of all the US dollar has been printed in the last 12 months (Time reference is Feb 2021).
Currency Printed The interest rates were again brought down to near zero percent (0.25%). Therefore, the Covid market crash was averted, and what followed was a huge bull run. Something like this was done during the dot com bubble in the early 2000s and the interest rates were brought down which actually instead of healing the economy delayed the pain eventually building up until the 2008 market crash. The same thing might have happened with the 2020 market crash.
History of US Interest rates- notice that the interest rates weren't increased from 2008 until 2016
People say that 2020 was a very bad year. But in no way was it a bad year. People got stimulus checks, Unemployment benefits, in simple words people got bailed out in so many different ways, and people didn’t even want to get a job because they were making more money staying at home than getting a job. In my opinion 2020 crash can’t even be called a crash because the market recovered within just a few months and why talk about recovering, it instead went into a huge rally. How can the economy be healthy if fewer people are employed? How can it be justified? And the sad truth about the stimulus checks is that most of it just flowed into the market, again rising stock prices. And again, the debt to finance this growth in the market is high just like in the 1920s and in 2008. And just like old-time wall street has invented newer financial instruments to get more money into the market, except that this time it is the technological instruments that are getting more money into the markets (like Robinhood-now more people have easier access to trade on margin). And now there is this rising discussion about how fraudulent SPACS are. And who knows what other financial instruments are being put to play since the last year. Now we are already at near-zero interest rates, so if there is a market crash right now, the fed can’t lower the interest rates to stimulate the economy as it is already at near-zero levels. So, no more stimulation if there is a market crash. And every time normal people who have never shown interest in investing, start getting into an investment, there is probably a bubble, it is because these are the people who are usually the last ones to get into an investment before it’s too late. This has happened in 1929, 2008 GFC, same thing happened with GameStop and every other time. And in the last year, the stimulus checks, the new money being printed, and new investors coming into investing through new tech instruments like Robinhood, have brought in insane amounts of money into the stock market. The Bull Run? It is financed by the new cash influx due to all these factors mentioned above. But of course, the fed can’t keep printing money, they would have to stop at some point, and this stopping of printing currency is going to scare the equity markets.
Private debt to GDP ratio
And taking a look at the buffet indicator, the ratio is at 213%. US market value is pegged at 50 trillion dollars and GDP at 23 trillion dollars. This ratio was at 150% during the dot com bubble and at 130% during the global financial crisis of 2007-2008. Anything above 125% was previously considered dangerous, but now it is at 213% which is insanely high and is an indicator of inflation.
Yes, companies are earning more now, but why are they earning more, it is because the fed is printing more cash and injecting money into the system, it is because the govt is giving money to people through stimulus checks, and people are buying with that money. And coming to the National debt to GDP ratio, the United States was at 128% in 2020, whereas China was at 66% last year. US national debt is at 28.9 trillion dollars which is also high. The recent debt-ceiling standoff has given a glimpse of how catastrophic federal default can be. If the debt ceiling isn’t raised it will lead to federal defaults which will have severe consequences on the economy. If the govt is not able to deliver on its commitments (borrowings) on time, it will lose the trust of the bond market, and the stock market would react to the bond markets, and this would be terrible.
It is likely that the fed is going to wait until 2022 to raise the interest rates. Then, will the market crash? Only time can tell. I would end by quoting Warren Buffet “Be fearful when others are greedy and be greedy when others are fearful” By Rishi D V